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Key rate falls to 1 per cent

The Bank of Canada slashed its key interest rate this morning by half a percentage point to 1 per cent, the lowest level ever, and warned the country&#39;s economy is in for a rough ride this year.

By Ann PerryBusiness Reporter

Tues., Jan. 20, 2009

The Bank of Canada slashed its key interest rate this morning by half a percentage point to 1 per cent, the lowest level ever, and warned the country's economy is in for a rough ride this year.

The drop in the overnight rate – the rate at which major financial institutions lend short-term money among themselves - is just the latest in a campaign of monetary easing aimed at reviving the country's flagging economy that has seen the central bank chop the key rate by 3.5 percentage points since December 2007.

"The outlook for the global economy has deteriorated since the bank's December interest rate announcement, with the intensifying financial crisis spilling over into the real economy," the central bank said in an accompanying statement.

"Heightened uncertainty is undermining business and household confidence worldwide and further eroding domestic demand," it added. "Major advanced economies, including Canada's, are now in recession and emerging-market economies are increasingly affected."

Canada's big banks almost immediately followed the Bank of Canada's lead, dropping their prime rates by half a percentage point to 3 per cent.

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The banks were heavily criticized last month for not matching the Bank of Canada's 75-basis-point cut on Dec. 9, instead cutting their prime rates from 4 per cent to 3.5 per cent. Consumer advocates argued the banks should have passed along the full effect of the rate cut to consumers in light of taxpayer-funded programs the federal government has provided to financial institutions to boost their lending capacity.

The Bank of Canada said that "bold and concerted policy actions" by governments and central banks are "starting to gain traction, although it will take some time for financial conditions to normalize."

The central bank painted a gloomy picture of Canada's economy. It predicted that real GDP will drop by 1.2 per cent in 2009, revising its October forecast for growth of 0.6 per cent this year. "Canadian exports are down sharply, and domestic demand is shrinking as a result of declines in real income, household wealth, and consumer and business confidence," it said.

The central bank also said that core inflation, which excludes some of the most volatile components such as produce and gasoline, will drop to 1.1 per cent in the fourth quarter, while total inflation will fall below zero for two quarters this year, reflecting plummeting energy prices.

But the bank did offer a glimmer of optimism. It expects real GDP to rebound next year, growing by 3.8 per cent, and core inflation to return to the bank's 2 per cent target in the first half of 2011 "as the economy returns to potential."

The bank said it will "continue to monitor carefully economic and financial developments in judging to what extent further monetary policy will be required."

The rate cut was in line with economists' expectations. "If global financial markets continue to stagger in the coming weeks, the bank still has the room and the willingness to cut further as the need arises," Douglas Porter, deputy chief economist at BMO Capital Markets, wrote in a research note.

But United Steelworkers economist Erin Weir argued the Bank of Canada should have made a much deeper rate cut and mirrored the U.S. Federal Reserve decision to take its policy rate to virtually zero. In a research note, Weir wrote that rising inflation will be "extremely unlikely for the next two years," and argued the central bank "paints a dire but accurate picture of a shaken economy desperately in need of stimulus."

"If inflation is not of concern and the economy needs stimulus, it seems that interest rates should be cut as far as possible to provide such stimulus," he wrote.

The previous low for the bank's key policy rate was 1.12 per cent in 1958.

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